What is the marginal cost of making a payday loan? Or any other type of loan? The answer to this question should help to answer a question about interest rates on loans raised in the Buttonwood column of The Economist, November 30, 2013 issue. What interest rates should lenders be allowed to charge?
Unfortunately loans and credit are complicated beyond simple economics because the making of loans is an instrument of exploitation even to the point of slavery and because credit is involved in how we create money.
Economic theory tells us that so long as there is competition the price of a product should be equal to the marginal cost of producing that product. Therefore for loans the marginal cost would be the cost to the lender of acquiring the money to loan (i.e. the interest paid to the depositor of for payday lenders to their source of funds) plus the operating costs and the cost of loans written off. The legitimate interest rate to charge on a loan should be easy to calculate and for banks we can compare the rates they pay on deposits and the rates they charge for loans.
It appears the need for credit is almost universal at least in large-scale economies. I’m not sure about hunting and gathering groups which practice a sharing economy. It appears there has always been a need for short-term lending of the type done by payday lenders.
The problem is that the making of loans can be an instrument of exploitation. One of the quickest ways to get control over a person is to lend them some money. In peasant societies people borrow to put on funerals and weddings and if they cannot repay they sometimes find themselves in slavery.
In our own society there are probably lots of people with dreams of doing something other than the daily employment but they are unable because of their debt load. All this consumer debt works as an instrument of social control for the one percent. So long as we are in debt we work to support their goals and interests rather than for our own. If a person wants to be truly free one should try to live without borrowing.
As for payday loans Mr./Mrs./Miss/Ms Buttonwood says:
“Provided the terms of the loan are made clear, then it should be up to borrowers to decide whether to accept the costs involved. An interest rate is simply the price of money.”
Once again this is simple economics without the human factor. For many people there are times when it may not be easy “to decide whether to accept the costs involved.”
The other complication with lending is that our money supply is based on fractional reserve loans by financial institutions. As money is essential for the exchange of goods and services it is also essential that we carry a debt load. Says Buttonwood
“But businesses and consumers are positively encouraged to borrow. Indeed, when debt growth slows, as it has in recent years, an air of panic develops about how to get it going again.”
There are a number of problems with the fractional reserve method of creating money, most of which have been discussed elsewhere on this weblog and especially in the essay “LETS go to market: Dealing with the economic crisis.” Basically it is a Ponzi scheme which is urgently in need of reform.
The reform proposed in that essay, a national Local Exchange Trading System (LETS) should also help with the need for short-term credit. It would be a lot less exploitive as no interest would be charged and control over the money supply would be in the hands of all people. A national LETS system would transfer a lot of economic decision-making from bankers and governments to individuals.
There are consumer loans and there are business loans. Loans are a transfer of purchasing power from one person to another and interest is compensation for the transfer. A LETS system should take care of the need for short-term consumer credit. The compensation for business loans should come out of the profits in which case they should be considered equity.
Back to the question of caps on interest charged on payday loans. Is it the role of government to prevent some of its citizens from exploiting others? If yes, then governments should limit interest rates charged (marginal cost is a guideline) or find another way of creating money so that the need for short-term consumer credit is easily satisfied.
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